BERKONOMICS – Business insights from Dave Berkus

For those of us who’ve invested in early stage companies, especially technology startups, we have confronted a universal problem.  There are many ways to project the value of a company for purposes of pricing an investment, but all rely upon the revenue and profit projections of the entrepreneur as a starting point.  Many formulas then discount those projections according to some set percentage or by assigning weight to elements of the enterprise.

And in my opinion, all fail to take into account the universal truth – that fewer than one in a thousand startups meet or exceed their projected revenues in the periods planned.

Years ago, confronted with the same conundrum, in the middle 1990’s I came up with a method of assessing the value of critical elements of a startup without having to analyze the projected financials, except to the extent that the investor believes in the potential of a company to reach over $20 million in revenues by the fifth year of business.

[Email readers, continue here...] First published widely in the book, Winning Angels by Harvard’s Amis and Stevenson with my permission in 2001, the method has undergone a number of refinements over the years, particularly in the maximum assigned to each element of enterprise value, reducing those amounts as the investment market adjusted from the craziness of the bubble to more logical values in the years that followed.  Because the Internet has such a long memory and documents from the distant past can be found with ease, a search the “The Berkus Method” today will yield a number of conflicting valuations culled from the many subsequent publications of the method over the ensuing years.

Here is the latest fine-tuning of the method. You should be able to adopt it to most any kind of business enterprise, if your aim is to establish an early, most often pre-revenue valuation to a start-up that has potential of reaching over $20 million in revenues within five years:

If Exists:                                                 Add to Company Value up to:

1. Sound Idea (basic value, product risk)            $1/2 million

2. Prototype (reducing  technology risk)             $1/2 million

3. Quality Management Team (reducing execution risk)    $1/2 million

4. Strategic relationships (reducing market risk and competitive risk)   $1/2 million

5. Product Rollout or Sales (reducing financial or production risk)         $1/2 million

Note that these numbers are maximums that can be “earned” to form a valuation, allowing for a pre-revenue valuation of up to $2 million (or a post rollout value of up to $2.5 million), but certainly also allowing the investor to put much lower values into each test, resulting in valuations well below that amount.

There is no question that startup valuations must be kept at a low enough amount to allow for the extreme risk taken by the investor and to provide some opportunity for the investment to achieve a ten times increase in value over its life.

Once a company is making revenues for any period of time, this method is no longer applicable, as most everyone will use actual revenues to project value over time.

In the creation of a new enterprise, there are five principal risks to be addressed by the entrepreneur.  Professional investors will probe these five risk areas and make the decision to invest based upon comfort with each.  So it is important for the entrepreneur to identify, address and mitigate each of these in order to increase valuation and decrease the risk of ultimate loss of the business.

First:  Product risk.  Is the product or service possible to produce at all, let alone economically enough to compete in the marketplace?  One way to mitigate this is by using early money to create a prototype, to perform market research, to complete the first generation of the product, or to deliver the service to a satisfied customer.

Second: Market risk.  Are you ahead or behind the market with your product or service?  Will the public respond in numbers to buy, license or rent your offering?  This risk can be mitigated by finding a customer willing to purchase as soon as a proven model is completed, and willing to state this in writing.  Another is to gain the support of a core vendor who is willing to offer special extended terms to the company as its investment in creating the product in a finished state.  A third demonstration of overcoming market risk is by holding controlled focus groups and gathering information from unbiased potential customers supporting the acceptance of the product or service.

[Email readers, continue here...]   Third: Management risk.  A great idea often fails from the inexperience or inability of management to bring the idea to market.  Similarly, great management often can manipulate an original idea or business plan into one much more attuned to the market, adding tremendous value that might have been lost sticking to the original plan.  This is sometimes labeled “execution risk” addressing whether management can create and run the company producing the product acceptable to the marketplace.

Fourth: Financial risk.   Any new enterprise is at risk if there are not enough resources to get the company to breakeven, which is a proxy for stability.  If a company truly needs five million dollars to get to breakeven, investors that provide the first million are greatly at risk of the company failing to raise the remaining capital or of subsequent investors valuing the company at a lower price than the first investors, causing a “down round” in which the early investors are punished for taking the first risk.

And fifth: Competitive risk.  If there are high barriers to entry with such protections as patents, long development time already spent or contracts with the major potential customers, then the risk of a competitor with more resources jumping into the frothy pool and taking advantage of the demand created by the company is minimized.

Reduction or elimination of one or more of these risks increases the valuation of the company and certainly improves its chances of survival and growth.

I cannot tell you how many times I have seen executive summaries of business plans in which the entrepreneur seeks $5,000,000 to build the business.

First, few startups can use that much money today with all of the virtual services available and increasingly inexpensive methods of development, prototyping and marketing. Second, almost no professional investor will consider putting that much into a startup until there is proof of market demand, product viability or some other mitigation of failure.

Third (if you’re keeping score), it is not wise to dilute the founder’s ownership greatly in the first round of financing.  The investors want a motivated entrepreneur, and it is certainly more difficult to motivate a twenty percent owner than a sixty percent owner.

Fourth, there is the matter of control.  Entrepreneurs have a vision for what and how to create and build a great business.  Giving control over that vision to others early on often dilutes the vision and is a disincentive to the entrepreneur.

[Email readers, continue here...] Professional investors love to see companies where the first round of financing came from the entrepreneur, showing “skin in the game” and more motivation to succeed because of money invested as well as time and creativity.

There are so many resources for early money to validate an idea, turn it into a product and increase the value of the company before professional investors come into the picture.

Starting with credit card debt or a personal loan and working through money from friends or family, or simply consulting to earn money for investment, entrepreneurs should consider early resources for capital to produce a prototype, do market research or start to build a team.  Once there is progress in any of these critical areas, raising professional investment is easier and the likelihood of a higher valuation makes for retention of more equity during the first important professional round.

   What if you are the seller of a previous business or shares amounting to more than an insignificant percentage of a previous business?  Certainly the buyer’s asset purchase documents included a non-compete clause, usually valid for two years from the date of the closing.  And because there was consideration paid to you in the sale, that clause is binding upon you and is effective almost everywhere.

                  Well, what if the buyer is now bankrupt?  That does nothing to regain your right to its purchased information.  The estate of the bankrupt company retains and can resell those rights into the infinite future.  (Patents expire after 14 or 20 years – depending upon type – and publicly disclosed patent information is no longer subject to the agreements after that expiration, as long as you use only the publicly disclosed information as filed within the patents themselves.)

 [Email readers, continue here...] What if the buyer abandons your previous product?  That does not change their purchased rights to it.  What if you invent a substantial enhancement or change to the product?  As long as you did not use patented processes or trade secret material from you previous company, you should be protected, but you might be prepared for a fight.

                How about after the two year limitation in your agreement?  Separate confidentiality from non-compete, and obey the confidentiality clauses.  The non-compete agreement does expire when stated.  But watch it. Some clever buyers try to slip in an unlimited non-compete, and some courts have upheld this.  And there are gray areas for former key employees who signed a non-compete with a limited life as part of the sale, but remained on for some time thereafter employed by the buyer.  Does the non-compete start anew upon the employee’s departure?  Courts tend to apply only the reasonableness standard to these gray area cases, looking to see how much the person now competing gained from the original sale.

                The safest advice is to avoid using any materials from the previous company, and compete only after the expiration of any written agreements or clauses signed with the buyer.

Professional investors want to live by this rule. With the first round of funding, there should be milestones to be achieved.  If they are not achieved within the expected time, the reasons must be analyzed and acted upon to avoid loss of capital beyond plan or expectation.

And if the vision of the entrepreneur is flawed, or the product impossible to create within cost and time expectations, or the demand impossible to quantify, or revenues never close to plan, then it is time to rethink the plan and product.  An excellent management team is perhaps the greatest asset for any company because it is just this team that has historically been able to make a drastic alteration of the plan, ultimately making a failing vision into a wildly successful one.

But if neither great management nor the entrepreneur’s vision for the product shows real signs of success in the market, it is the hope of professional investors that the company fails fast, reducing further expenditures of remaining capital and protecting the assets purchased with the original investment.

[Email readers, continue here...] My favorite story of a fast failure was of a technology incubator started in the year 2000 with optimistic money from a number of angel investments, including mine.  Within a month after the tech crash, the founder of the incubator (who remains a close friend) decided that it made no sense to incubate companies that were not likely to receive new investments soon following incubation in the winter-of-cash that followed the tech crash.  He volunteered to close the incubator and returned 96% of our investments to all of the angel investors.  (That return proved to be the best investment return any of us saw in the several years that followed.)

Half of all professionally managed venture capital or angel investments fail.  There should be no shame to the entrepreneur in admitting such a failure.  Some angel and VC investors will give special credit to those entrepreneurs who have experienced failures when investing in their next effort.  The lessons learned are difficult to teach and are great assets in the next effort.

Yes, this is a takeoff from Frank Sinatra’s song, where he did it his way and got away with it.  You’re building a company from your vision and a passion, and lots of people are going to tell you that you have this or that wrong, and that it just won’t work.

The truth is that very, very few early business plans survive in a form completely recognizable when looking back a few years.  But even with massive changes, the vision and passion usually don’t diminish in the process of morphing a business plan into a profitable business.

Investors will invariably try to tell you that they know much more about the “how to” than you do, and that you should listen to them.  And because you need their money, the temptation is to listen a bit too well, and take all of the advice thrown at you during your presentations and during due diligence and finally from the vantage point of a board seat.  A good entrepreneur-turned-CEO listens, takes it all in, responds with reason, and stands up for what s/he believes for the parts that matter most.  It is good to listen.  And it is better to assimilate the best suggestions into your cake as you bake it. 

[Email readers, continue here...] But there is a limit, a point where your gut is more important than your ear.  If you reach that point with suggestions from these people trying to help, think carefully about how to respond, whether with facts, instinct or support from others.  Make your case for staying the course.  Remember the same passion you demonstrated when you first attracted these well-meaning helpers.  And push back.  Some investors may drop out if you are in the pre-funding stage. But they are not the ones whose support you would later want.  Some board members may show dismay.  But most often, a good case made with passion wins the day and unites the group to move forward.

I was chairman of an excellent company where I had led the deal, attracting angel investors through several rounds as the company grew to a breakeven with over four million dollars of gross revenues.  We then sought and received a venture investment from a top tier Silicon Valley VC firm, whose partner came onto the board.  After several months on the board, he spoke up. “I don’t like the niche we’re in. It will never grow enough to make this a valuable company. Forget this niche and turn the battleship. Let’s go after the Fortune 50.”  “But that’s walking away from an industry where we are #2, growing nicely and already becoming profitable,” the CEO responded. 

“Don’t worry. We’ll be there in six months when you run out of money with your new R&D focus”, the VC board member replied.  The rest of the board, including myself, went along with this because, as I’ve stated often, the last money in has the first say.

Can you guess the end to the story?  Six months later, the company ran out of cash, as planned, when ceasing to focus on the original niche. And the VC firm’s partners voted not to fund the restarted venture.  A good company, in a fine industry, ended up being dismantled just to repay the bank loan. No investors received anything. And the rest of us just shook our collective heads.  No one stood up to the VC board member, even though all of us heard but ignored our respective gut responses pushing back, as we remained silent.

It is years later, and the memory of that failure to push back remains fresh for me and surely for the rest of the former board members.  As chairman, I should have pushed back.  Certainly the CEO-founder had a duty to push back.  Another VC from a smaller company should have pushed back.  In retrospect, we were intimidated by the first tier VC, and half wanted to believe that he knew something we did not.

He did not.  Now, with that lesson firmly behind, I often remind members of a board when in a situation where someone on the board pushes to change the plan that the vision of the founder ignited us to bring us together.  If we believe we have a better idea, we should convince the founder and the rest of the board that we have strong beliefs that dispute the current plan.  But we should not be so loud as to drown out those other voices – you know – the ones from the gut and that of the founder’s dream.

 Fifty percent of all businesses formed fail within the first two years. 

There are many variations of this number since there are a number of ways to measure failure.  But the number is a startling reminder that creating a business is not easy, nor is it any assurance of success. 

After speaking with many entrepreneurs over the years, each defines success in his or her unique way.  To some, it is independence from the dictates of a boss who doesn’t appreciate that person’s talent, foresight, or abilities.  To some it is financial security, building a base of wealth created from the increased value of the enterprise at the end point of sale or at an IPO.  To others, it is simply a way to express a talent for art, cooking, consulting, management, development or more. 

[Email readers, continue here...] Everyone has a vision when starting a business.  And few think of the risks that increase over time as initial capital is expended.  We all see the examples of well-known successful entrepreneurs, many in our chosen field, who achieve success by anyone’s measure, and we optimistically expect to emulate these role models with at least some level of success. 

The best advice to anyone considering this course of action is to measure one’s ability to take the risk.  That ability varies with economic status, age, responsibility to family, and more.  If there is enough freedom to make that leap, then the journey can more safely begin.  If not, there are alternatives, such as raising initial capital from friends and family, before leaving the life boat of a present job. 

Some say that taking the leap, burning the bridges, the life boats – or whatever security is left behind – forces the entrepreneur to focus like never before and succeed because there is no alternative.  Although investors may respect that bold a move, it is so dangerously risky as to be a bit insane.  Then again, with the fifty percent rule, aren’t all entrepreneurs a bit insane to start?

People argue over whether an entrepreneur with a sense of fairness, a desire for collegiality, a want to share the profits can succeed in the long run within a business world full of lions and tigers that eat timid entrepreneurs for lunch.

First, let’s separate the “good heart” from the issue of whether an entrepreneur is driven to succeed. A sense of values that allows for sharing and fairness is not at odds with a ‘type A’ entrepreneur driven for success.

What is important is that stakeholders (people working for and with the entrepreneur) accept the entrepreneur for his or her good intentions, sense of fairness and willingness to listen.

[Email readres, continue here...] I have had numerous experiences during my business career where business people I dealt with took advantage of the moment selfishly because they could, not because they should. I recall an executive who kept a large deposit but canceled a contract, refusing to negotiate, because the next payment due was a few days late. Or another who sued over a gray area issue, refusing to listen or negotiate. (He lost the suit and paid both sides’ fees.)

And I have come to the conclusion that “good guys” (men and women) do finish first. There is no scientific proof, no metric to measure the full meaning of “good.” and no special acknowledgement from any “good-watching” organization. Even without these, I am sure of this.

Surely the ruthless more often win in the short run. But early successes, built upon the broken backs of adversaries, are rarely followed by long- term wins for the tyrant or for the tyrant’s company.

Be of good heart. You will enjoy your entrepreneurial or managerial ride much more, and your stakeholders will follow you through the flames as well as cheer your successes.

There is nothing quite as thrilling in business as igniting a startup and watching it blossom.  Especially when starting a company with personal savings or money from relatives and friends, early signs of success are intoxicating.  Each new customer, each mention in the press or online adds to the feeling of early accomplishment. And it is more satisfying because it is yours, from idea to execution.

But the excitement begins much earlier.  With newfound freedom to make independent decisions about finding a company name, where to locate the company, whether to lease an office or start from home, how to engage talent, even whether to provide free coffee to employees,  the newly minted entrepreneur can only think of positive thoughts and great outcomes.

[Email readers, continue here...] This moment is not to be spoiled by such mundane warnings from advisors or consultants to plan carefully, research the market and competition, and execute the plan with tenacity and enthusiasm.  This moment is to be enjoyed for what it is: the ignition point in which the dream becomes a reality and anything is possible.

This moment is to celebrate every action, including shopping for supplies, furniture and technology to support the newly minted enterprise.  There is never again going to be such a pristine, simple, problem-free time in the life of this business.  Relish the experience of creation.  Celebrate each important “first,” including the first customer order, the first day in a new office, the first new employee hired, the first earned dollar actually deposited into the bank account.

Because it is yours to write alone, there is no Hollywood script more thrilling than the one you create during those first days when everything is so very new.

This week, for the first time, we republish an earlier post.  With readership up three-fold since that posting in April, 2011, and with many great reader comments then, it is only natural to send you to the original post with those reader comments attached, rather than republish it here.

So press this link to go right to that original posting.  And thanks for your many comments and emails after last week’s final posting in the first cycle of BERKONOMICS.  Be assured that the tank is not nearly empty, as we begin the second cycle examining the stages of corporate growth from startup through raising money, marketing, board-building, protecting the business, and more, including cashing out.

Stay tuned!

- Dave